NETGEAR, Inc. (NTGR) Q2 2013 Earnings Report, Transcript and Summary

Greetings, and welcome to the NETGEAR, Inc. Second Quarter 2013 Earnings Conference Call. [Operator Instructions] It is now my pleasure to introduce your host, Christopher Genualdi, Investor Relations Specialist. Thank you, Mr. Genualdi, you may now begin.

Thank you, operator. Good afternoon, and welcome to NETGEAR's Second Quarter 2013 Financial Results Conference Call. Joining us from the company are Mr. Patrick Lo, Chairman and CEO; and Ms. Christine Gorjanc, CFO. The format of the call will be a brief business review by Patrick, followed by Christine providing detail on the financials and other information. We will then have time for any questions. If you have not received a copy of today's release, please call NETGEAR Investor Relations or go to NETGEAR's corporate website at www.netgear.com. Before we begin the formal remarks, the company advises that today's conference call contains forward-looking statements. Forward-looking statements include statements regarding expected revenue, earnings, growth, operating income and margins, tax rates and other projected financial results, expected market share gains and market size for our products, business prospects, competition, research and development efforts, sales and marketing efforts, market trends and opportunities, service provider or purchasing expectations, new product features and pace of new product introduction, our growth strategy and expectations regarding our recent AirCard acquisition. Forward-looking statements made during the call are made as of today. If this call is replayed or reviewed after today, the information presented in the call may not contain current or accurate information. Further, certain forward-looking statements are subject to certain risks and uncertainties and are based on assumptions as to future events that may not prove to be accurate. Therefore, actual outcomes and results may differ materially from what is expected or forecast in such forward-looking statements. Information on potential risk factors are detailed in the company's periodic filings with the SEC, including, but not limited to, those risks and uncertainties listed in the company's most recent Form 10-Q filed with the SEC. NETGEAR undertakes no obligation to release publicly any revisions to any forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the accuracy of unanticipated events. In addition, several non-GAAP financial measures will be mentioned on this call. Information relating to the corresponding GAAP measures, as well as a reconciliation of the non-GAAP measures and GAAP measures can be found in our press release on the Investor Relations website at www.netgear.com. At this time, I would now like to turn the call over to Mr. Patrick Lo. Please go ahead, sir.

Thank you, Christopher, and thank you, everyone, for joining today's call. For the second quarter of 2013, NETGEAR net revenues were $357.7 million, which is up 11.6% on a year-over-year basis and up 21.9% sequentially. Please note that Q2 2013 is the first full quarter that includes the revenue of the AirCard business acquired from Sierra Wireless. Non-GAAP diluted EPS came in at $0.62 per diluted share. Please see the second quarter 2013 earnings press release for a full reconciliation of GAAP to non-GAAP financial results. During the second quarter, net revenue for the Americas was $200.8 million, up 22.9% year-over-year and up 28.2% quarter-over-quarter. We are very pleased with our results in the Americas, which show growth for both retail business unit and commercial business unit on a year-over-year basis. With the integration of the AirCard business going smoothly thus far, we are also seeing strong year-over-year and sequential gain in our Service Provider Business Unit business in the Americas. Europe, the Middle East and Africa, or EMEA, net revenue was $108.4 million, down 8% year-over-year and up 1.2% quarter-over-quarter. Europe continues to be a sluggish market for us due to ongoing economic headwinds. We are seeing weakness in end market demand for all 3 business units, and we expect to continue to face challenges in Europe in the upcoming quarters. Our Asia Pacific, or APAC, net revenue was $48.5 million, which is up 23.1% from the prior year's comparable quarter and up 63.9% sequentially. We continue to see strong growth in both the RBU and CBU business, while the addition of the AirCard business has bolstered our Service Provider business in Australia. In Q2, we maintained a high level of shipments with 6.7 million units shipped. We also introduced 22 new products during the quarter. By the end…

Thank you, Patrick. I will now provide you with a summary of the financials for the second quarter of 2013. As Patrick noted, net revenue for the second quarter ended June 30, 2013 was $357.7 million as compared to $320.7 million for the second quarter ended July 1, 2012, and $293.4 million in the first quarter ended March 31, 2013. We shipped a total of about 6.7 million units in the second quarter, including 5.2 million nodes of wireless products. Shipments of all wired and wireless routers and gateways combined were about 3.4 million units for the second quarter of 2013. Moving to the product category basis. Second quarter net revenue split between wireless and wired was about 67% and 33%, respectively. The second quarter net revenue split between home and business products was about 75% and 25%, respectively. Products introduced in the last 15 months constituted about 43.8% of our second quarter shipments, while products introduced in the last 12 months constituted about 40.2% of our second quarter shipment. These numbers include the AirCard portfolio of products. From this point on, my discussion points will focus on non-GAAP numbers. As mentioned previously, the reconciliation from GAAP to non-GAAP is detailed in our preliminary financial statements released earlier today. Non-GAAP gross margin in the second quarter of 2013 was 29.8% compared to 29.9% in the year ago comparable quarter and 30.5% in the first quarter of 2013. Total non-GAAP operating expenses came in at $69.9 million for the second quarter of 2013. We continue to invest in research and development in order to drive innovation in all 3 business units. Our non-GAAP R&D expense for Q2 was 6.4% of net revenue as compared to 4.4% in the year ago comparable period and 5% of net revenue during Q1. The higher…

[Operator Instructions] Our first question comes from Ryan Hutchinson from Lazard Capital Markets.

So just I want to dive into the guidance a little bit more and understand it and make sure we're on the same page. You guys are clearly entering your seasonally strong part of your fiscal year and you're guiding down quarter-over-quarter to midpoint. You touched on Europe and cable NSOs. But if you just look at it by business unit and relative to historicals, can you just help us understand how we should think about the RBU, CBU and Service Provider? And then within Service Provider, the contribution for AirCard in the second quarter would be helpful in what you expect with respect to the contribution in Q3.

So again, we've rolled out the forecasts, it's what we see, and what we see is EMEA is slowing down, both in the Service Provider and in the RBU, and especially and obviously in the cable. So we're guiding to what orders we have. As we said, we always typically have Service Provider ahead of the game. We are seeing -- we expect a good back-to-school in the U.S. We did expect a less-than-normal back-to-school in EMEA for RBU, which we'd still say, the potential -- they should be up for the quarter, just not up the normal amount that we would expect it to see. CBU, we expect to go strong with the storage products out there and the 10-gig switches in that. As far as AirCard is really included within the Service Provider, and we're already managing it that way, so we really are looking at these all mobile products sold, so we're not really giving the numbers. But I think the last number you saw was probably from them, with Q4, probably 12%, about $54 million. And as we said, we felt like we would be in that range, and we're pleased with that. And we expect that business to grow, but it'll grow also with the mobile broadband gateways in that. So it won't just be the mobile hotspot is how we're going to measure that business.

Okay. And just to be clear on that, then, it's broadly within -- AirCard contribution is broadly within that historical range, and that's expected to be consistent in the third quarter as well with the primary driver being the Cable MSO decline based on the lead times that you have? Okay.

Yes.

Okay, and then one follow-up then, on just the pipeline with respect to the LTE gateway products. Patrick, I know you've been busy traveling and trying to knock down Service Provider opportunities there. Can you just update us as to where you think you are with potential wins, and when those could materialize and hit the P&L?

Yes, I mean, we are making progress in all of the RFPs and we'll make announcements when our customers allow us to, so stay tuned.

Our next question comes from Rohit Chopra from Wedbush Securities.

Christy, I just wanted to get a sense of have you guys thought about a repurchase with the $7 in cash that you have. That's my first question.

Sure. I mean, we're actively looking at that versus how we might spend the money that might be accretive to NETGEAR on the net income side, so that's a very active conversation, I would say.

Okay. And then Patrick, do you want to talk about Google's new product that they have for TV and the potential impact on our business for the retail side?

Well, clearly, I mean it's another entrant, which validates basically our view that this market would continue to grow and will continue to have less dominance of 1 or 2 players. And clearly, Google is trying to win more support, and we are one of the supporters. I mean they have the 2-pronged strategy. They have the Google TV, which we are a supporter, and clearly, we would be in close discussion with them on how to support the Chromecast. Today, we are pretty much the only one out in the market, which has an interoperable Push2TV device that supports both Miracast as well as WiDi. So we believe that this market is being validated to be a good one. And with the proliferation of people watching video on their cellphone -- smartphone, this is a good technology. And the more people know that they could transpose videos from the mobile devices, be it a tablet or a smartphone, onto the TV, it will benefit the industry as a whole, given the fact that we have over 60% of the retail shelf space in the U.S. and actually, in Europe and now, in China as well. I think we're well positioned to see this upswing of the Smart Home market.

Okay. And then I just wanted to get the sense on CBU. You mentioned the switches, you mentioned the storage sort of coming back after you got all the products out. Is there anything there that we should look forward to in the second half on the CBU? And related to that, is John expecting to sort of ramp up the sales force there? Is there more investment that has to happen on CBU?

Well, I think in CBU, we are actually in the right place. We've spent the last 2 years in both R&D money, as well as in acquisition to position us in the 3 fastest-growing market on the commercial side. I mean, 10-gigabit switches, wireless -- campus-wide wireless LAN, kind of BYOD network, as well as storage. All 3 markets are growing double digit on a worldwide basis. And again, I mean, we have a strong reseller base of over 40,000 resellers from around the world. We're very well positioned. And the products that we have today is second to none. I mean, we have the first breakthrough 10-gigabit switches for sub-$1,000, no competition over there. We have our enterprise-class storage products, which would enable our customers to have data protection, such as unlimited snapshots and remote replicate that, frankly, is right at the capabilities of the NetApp and EMC but much easier to use and maintain. And then from a wireless LAN perspective, needless to say, I mean, there are so many new startup players that have been enjoying market acceptance, and we're now a pretty credible entrant to that. And we're very excited about being able to gobble up more share. So based on these 3 platforms, I think John has a good arsenal of weapons to take us to new heights.

Okay. And my last question is really just related to competition in Europe. Is that -- EMEA has been weak for a while, not really new story. So have you noticed any incremental change in EMEA as far as competition cropping up in anywhere, in any places, any countries?

Yes, we do. I mean in Europe, it's an interesting market. There is a lot of a local indigenous competitors and there's also a lot of Chinese, Taiwanese competitors. What we're seeing is that even though Linksys has not been very strong in Europe, they did have a few niche market, which is right now basically under siege that we're taking share away from them. For example, they traditionally have been very strong in Benelux because it's their headquarter, Linksys headquarter over there, as well as in Spain. And that's being taken away by us. And also D-Link has been weakened, especially in Europe by another new Chinese entrant called TP-Link in the low end of the market. And also, some of the low-end brands in Europe, such as SiCom, such as Hercules, those people also being eaten up by these new Chinese low-end entrants. Those are the notable differences, but we continue to maintain our share and we continue to believe that we will be able to gain share against the remnant of Linksys and the 2 markets that I mentioned.

Our next question comes from Hamed Khorsand from BWS Financial.

Just a question on the guidance. So if I look back to the last earnings call, you had given operating margin range of 9.5% to 10.5%, and obviously, it was diluted by the wireless -- the AirCard business. So now we look forward to Q3, you're giving the same range, and you're saying Service Provider is going to be down. Usually, Service Provider is a drag on the business. So how -- why is the operating margin metrics going up on top of you saying that the integration process is going well?

I think, again, we guide to what we see, and we have our R&D investments that we're spending on in that, and we believe, as we look at that range, that, that is where it's going to come out, but we are clearly making some investments also within that number. They're coming out to the 9.5%, 10.5%.

Okay. And then, do you think these investments are going to result in revenue growth within 12 months, or are we looking more at the longer-term kind of growth opportunity?

I absolutely think it will result to some revenue growth in 12 months. I mean, take for example the Indian development team we just bought the assets to add to our other one on the wireless LAN market that Patrick talked about. So we believe these products will come and we'll be selling those in 12 months, and it's important to enter those markets at this time.

Well, as I mentioned, and I mean, also -- I mean, we're in multiple RFP situations for the LTE gateways that's really way in advance. And as you know, at the beginning of that product cycle, you really have to spend a lot of money in making those headways. And you're not going to reap the benefit until you start shipping those products, which is pretty similar when we first entered the DOCSIS 3.0 market. We spent almost 2 years of R&D until we really hit the revenue stream. So right now, we're in that investment stage. Even though we acquired AirCard, we continue to pump more R&D into it to try to win all these RFPs out there. Just to give you an idea, just certify against one network is going to cost upward of $0.5 million and just to participate in RFP. It's a lot of money.

Does this delay your timeline as far as getting back to that 11% to 12% range?

Well, certainly. I mean, it's part of the consideration. But as we see it more and more -- well, there are few things, right? One, when we see more and more growth on the RBU and the CBU side, they would help us to get back to 11% and 12% as quickly as possible. And then if we hit 1 or 2 of these LTE win, then they help us to get into the 11% and 12% as well. And I could assure you, the whole team is very focused in getting back to 11% and 12% as soon as possible.

Okay. And then last question, on the service provider and in Europe, I mean, how much of a glut of inventories is there that you're going to see a decline in revenue for the next 2 quarters? Or is that just not the case, and there's just no one buying anything?

; It's not a -- we really have no visibility of what the inventory is because they never report back to us. But the fact of the matter is you probably know, a lot of the big operators in Europe is being gobbled up by U.S. company. And when you have new management coming in, they always want to relocate the business, how it should go forward and things like that. So everything is put on hold. So we do not know, I mean, when they're going to restart the normal purchase process. So for the time being, when we don't see the orders, which is 13 weeks in lead time, we're not going to forecast it.

Right. So does this mean that maybe, when all this settled down, we could all of a sudden see large sequential increase in the Service Provider revenue?

As usual, right? These mergers and acquisition's new management is unpredictable. We do not know where it's going. I mean, of course, in the best case scenario, we may even gain some accounts because of the merger, right? But it's hard to predict.

Our next question comes from Mark Sue from RBC Capital Markets.

And just on service providers, I guess, if I look chronologically and just back at the last several years, you had one big Service Provider customer and there was a beginning, a middle and an end. And I guess, everything is -- right now, at the moment, the challenges is you just don't have any big service providers that backfill that. So -- which is why, I guess, the organization is elephant-hunting, looking for big service providers out there. At the same time, a lot of these European service providers are very challenged. They're really reducing their CapEx and trying to cut their dividends as well. So is it likely that we see a return in the service providers -- generally, when we look at technology, there's a lot of RFP; they could take many, many years. Maybe if could give us a sense of what's going on out there in terms of what you could really realistically grab.

Well, I mean clearly, our focus is continue to maintain the accounts that we have on all the DOCSIS 3.0 equipment, and then go hunt for new opportunities in the LTE. LTE is a growth market. The LTE gateway is a brand new market, and we're first there. So our hope is that we will be able to win 1 or 2 of those big customers while not losing sight on keeping the existing DOCSIS 3.0 customers happy. As a matter of fact, I mean, we do have quite a few of big -- especially now with the addition of AirCard, we actually have quite a few big accounts. I mean, for example, I mean it's known that AT&T is a big customer of our DSL gateway, and they are a big customer of AirCard's mobile hotspot. Combined, they probably is up there as one of the biggest service provider customers. Same thing is Telstra. So we do have more than one big service provider customers right now with the AirCard folded in. Our objective is continue to be their best supplier. And then on top of that, we'll continue to add more service provider for that size so that we could kind of even out our risk.

Patrick, in terms of quantifying the opportunity, these big LTE wins, are we talking 2 or 3, 10s? And timing wise, in terms of what you can mean for revenues, will it -- it doesn't sound like it'll be this year; it'll be more 2014 if you win it?

Yes, and as you mentioned, right, it would take a long time, these RFPs, and it's unpredictable. And if you talk about [indiscernible] if you just look at the world's top mobile operators, there are at least 20, 30 of them.

Not the number of carriers, but the actual RFPs you can respond with solutions to.

Oh, yes, it's the same thing. I mean all of them are -- having looked into these LTE gateway is just a matter of how many we could handle. And I could tell you, we definitely are handling a lot for now.

Okay. Patrick, a little while ago, I guess the thought was that NETGEAR would reach $2 billion in revenues next year. It doesn't look like that might happen even if you bought -- made more acquisitions at 1x revenues. With that in mind, what's the thought of shareholder returns? The stock has really been flat for many years now in terms of dividend, in terms of a share repurchase now that the growth has slowed down, but the cash generation is actually improving.

Well, I mean clearly, we would look at all options to create value for shareholders, either by increasing our EPS or by share buyback. Either way, we will always look at that. I mean, we, right now...

Do you have a preference? Do you have a preference, one way or another, at the moment?

I mean clearly, you see which one will, in the long-term basis, that will enable us to grow EPS, all right? For example, I -- it's been clear that by buying AirCard, all right, we immediately boost our EPS, increase our revenue, get us closer to $2 billion, yet at the same time, they actually enable us to be the credible contender to all the RFPs that I talked about in LTE. So basically, this is not a one-time event. This -- after the investment, they would amplify itself 2, 3x over. So that is absolutely a sensible choice for us to make. And going forward, we do believe that we would continue to look at that angle, which one has the best long-term benefit for us to increase EPS continuously. Now I mean about the $2 billion, clearly, to get there next year, we have to grow, organically, significantly faster than this year, closer to our historical rate of 20%-or-so. And of course, we constantly will look at any accretive inorganic acquisition that will get us there earlier. This is basically what we are looking at.

Our last question comes from Kent Schofield from Goldman Sachs.

Just a followup on the commercial side of things. Given the sequential growth we saw in June, how should we think about the third quarter in terms of sequential growth? It would be helpful as we try to look at modeling.

Yes, certainly, we do not have a crystal ball, what Q3 looked like, but our intentions to at least maintain that pace or even increase it a little bit. I mean, so that's what we see going forward. But on a longer-term basis, we still see a lot of growth opportunities on the CBU side because of those 3 markets that we're now in which is storage, 10-gigabit switches and wireless LAN. All 3 markets are growing double digit on a worldwide basis, which you don't find that easy in this market.

Okay, great. And, oh, just as a clarification, the new engineering team from India, was that acquired earlier in 2Q or was that more recent? Just trying to get a feel for if that's impacted the P&L yet.

Yes, sorry for the confusion. We did 2 acquisitions in India. One was in last year in Q2. That is for the wireless controller. And the company that we acquired is part of Firetide. Then we also acquired another small team of engineers in Q2 this year that's primarily for the access point software that couple with the controller, and the company is called Arada. So we did 2. Both are around the same price range of $5 million. Both are around the same number of engineers of 20. Both are in Bangalore.

Okay. And was it early enough in 2Q '13 that we saw -- we already saw that expense that there is not going to be an incremental step-up, or in 3Q?

Yes, we started middle of the quarter on that. I mean, you see the headcount and all that in there.

Okay. And then on the 802.11ac, thank you for the metrics there, that's helpful. Maybe you can give us a little bit of historical context and how that compares to, and given where we are at in the cycle.

I would say, in the North America, it's much quicker than end. And in Europe, it's just about the same pace.

Thank you, at this time, I'll turn the call back over to our speakers for closing comments.

Okay. And I would like to conclude. Again, I mean clearly, we are in a transition right now. We're, at the same time, starting to capitalize on a few high-growth markets, such as Smart Home, which I talked about; the North America Smart Home product market is growing at 30% plus year-over-year; as well as storage, which according to our latest report, the worldwide is growing at 15% to 20%; 10-gigabit switches, which is doubling, tripling every quarter; and then on the wireless LAN market, which according to the latest market report is growing 15% plus. So we're in a transition of going into these 4 high-growth markets; and of course, the LTE market, we believe, is going to burgeon to big, pretty soon, while we try to maintain the old products, the old segments. So I think once those 5 markets become significantly bigger for our base, as well as our growth, we will back in to our more traditional organic growth range of about 15% to 20%. So we are very excited about the product portfolios, as well as the R&D teams that we have in place to capitalize on all those 5 growth markets. And we're about to report back to you all for new wins going forward. For this quarter, we're super excited about the participation and the partnership with Lenovo in China, which would be really propel us into a significant platform into the BRIC marketplace. So we look forward to talk to you again in the next earnings call. Thank you. Bye-bye.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.